The Importance of Interest Only Loans

  • The Importance of Interest Only Loans image

Most investors pay interest only on their loans, at least in the initial stages, so that they can build their portfolios without getting trapped by too much debt.

Lenders usually offer interest only periods of up to five years, after which an investor is expected to begin paying down the principal value of their asset.

If the investor wants to continue paying interest only, they may be able to refinance to another lender and begin again, until it suits their strategy to start paying down the property.

Unencumbered cashflow

Paying interest only means the property is more likely to be positively geared…as in, the rental income will cover what you pay the bank and then some on top of that, which you can use to fund investments elsewhere.

Say for example, you borrow $200k for an investment property. Even with higher interest rates of 6%, that’s $12,000 a year you must pay in interest. To cover that, you’d only need $230 a week in rent. Rents in most suburbs are well above that mark. So that’s extra money in your pocket that you can use as you wish, rather than spending every spare cent on a mortgage.

Equity gain

You have no ownership over the property itself until you pay down the principal, but interest only investors can still access the equity…that is, the increase in the property’s value.

If your $200k property increases in value by $50,000, you can use a portion of that – known as useable equity- to purchase your next asset. Combining that equity with the savings you are able to accumulate with the extra rental cashflow on your first one means you can get a pretty handy deposit together in a relatively short period.

Depending on strategy, some investors can build a portfolio of more than 10 properties before they begin paying down principal value on any of them.

Max your tax deductions

Interest paid on loans for investment properties is all tax deductible. If you’re only paying interest, you can claim the entire payment in your tax return. Ongoing tax deductions mean plenty of investors are in no hurry to pay off their investment properties; instead putting their extra cash into their permanent place of residence or other pursuits.

Exit strategy

As b Invested founder Nathan Birch often says, inflation will make the existing debt irrelevant one day. If you had bought a house for $50,000 in 1970 and only ever paid interest on it, you’d still owe $50k on it today, which you could pay off with a year or two’s rental income.

But, even so, Nathan also always says it’s important to have an exit strategy.

If you want to create passive income streams and a portfolio that is unencumbered by debt, you need to pay off your properties outright at some stage.

The beauty of inflation, and an initial interest only period, is that you have the chance to raise rents over time so that you get to a point where the property will still be positive cashflow even when you’re paying down the principal. If you can achieve this with multiple properties, you have a handy bunch of assets paying themselves off over time. One day, they will be debt-free, while having increased significantly in value, and will be producing income tied to inflation. The portfolio can be handed to your children and grandchildren, to sustain them, without ever needing to be sold off.



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